The equity markets seem to have finally realized that conditions are ugly in the credit markets, due to get uglier, and the mess will pull down the real economy.

And the bad news continues.

The dollar index fell to a new low. Wachovia said the value of its subprime securities, largely “super senior” tranches of CDOs, fell $1.1 billion and it was witnessing sharp falls in housing prices in some areas of the US.

We had questioned the optimistic assumption of a few weeks ago, that investment banks were taking deep enough writedowns to put their woes behind them. How can you possibly do that unless a market is at or near bottom? Wall Street analysts have indicated that they expect further writeoffs at the Wall Street firms. Consistent with that view, Bank of America and JP Morgan said in their SEC filings that the fourth quarter would bring more writedowns. In particular, Bank of America noted that it expected “significant dislocations” in the market for CDOs. Fannie Mae reported a loss double that of a year ago. Capital One said it was seeing a faster-than-expected increase in credit card delinquencies.

But what I believe will be the largest single source of trouble in this sorry credit picture is coming to the fore: collateralized debt obligations.

CDOs are structured investments that contain a variety of assets, often tranches of residential mortgage securitizations (often the BBB or BBB- portion), commercial mortgages, pieces of collateralized loan obligations (LBO debt), and sometimes whole residential mortgages, There are also CDO squared (CDOs made from CDOs) and CDO cubed, and synthetic CDOs (CDOs constructed from the cashflows of credit default swaps written as credit enhancement for other CDOs). Because the assets in CDOs are heterogeneous, and the mix is particular to each deal, the structures vary tremendously as well.

There is no method for reporting on CDO issuance or on subprime loans outstanding (there are classification issues for subprimes, and that is compounded by the fact that many of the originators were mortgage brokers who had no reporting obligations). But to give a sense of relative importance, the estimates we’ve seen of the size of the subprime market range from $1 to $1.3 trillion (rated subprimes are $565 billion). By contrast, the estimates of CDOs outstanding are all over the map, but the ones we find more credible range from $2.0 to $3.9 trillion (we have also seen smaller estimates, but when the Financial Times, which has done far and away the best job of covering this market, reports that global CDO issuance in 2006 alone was $2.6 trillion, we tend to put our faith in the bigger numbers.

The reason for the disparity may have to do with what was counted. There are both passive CDOs, which are more like a conventional asset backed securities deal, versus managed CDOs, in which funds are raised on a blind basis and given to a CDO manager, who then buys the CDO holdings and can and does trade the holdings to improve results It is also an open question as to whether the variation in estimates is due to the inclusion or exclusion of synthetic CDOs, whose assets are credit default swaps written on CDOs. One source reported that synthetic CDOs were nearly 1/3 of total CDO issuance in the first quarter of 2007.

As readers probably know all too well, CDOs had been valued using models that the rating agencies had developed solely for credit rating purposes. Investors had carried CDOs on their books at more that they were probably worth, at first out of ignorance, because they didn’t realize the subprime paper they held was weaker than it had been historically, and later out of convenience (why recognize losses if you don’t have to and no one else seems to be doing so either?). And the investment banks were similarly able, in the absence of price discovery, to carry the CDOs on their books (they wound up owning them by not being able to sell out the full amount they created) without marking them down too much.

Those days are rapidly coming to an end. CDOs were the big culprits in the Merrill and Citigroup writedowns. And we have two developments coming to a head on the same time frame. The first is that new accounting rules gives companies far less latitude in how they value this paper. As the Financial Times explained it:

They are the “buckets” into which financial statement preparers must classify financial assets under FAS 157, a new US accounting standard for financial years beginning in November…

At the top of the bucket hierarchy is Level One, involving assets with prices quoted in active markets, such as mainstream stocks. Level Two contains less-traded securities and uses prices for assets very like the one being valued.

At the bottom lurks Level Three, assets with “un observable inputs”, meaning their value is calculated via a series of assumptions. Most collateralised debt obligations end up here.

While these categories may be familiar to many readers, what is not as widely know is that another rule, FASB 159, pushes institutions to put positions into the lowest bucket possible. Thus, no phony-baloney Level 3 valuation if there is a way to come up with a gridded or extrapolated Level 2 value.

The second development is that markeplace changes are forcing the revaluation of CDOs. Having first gone through re-rating subprime bonds, they are now tackling CDOs, and downgrades will force commercial banks, investment banks, pension funds, and other holders to recognize losses.

Fire sales of mortgage assets from complex debt vehicles began in earnest after the trustee of a $1.5bn complex debt deal managed by State Street Global Advisors started liquidating its portfolio.

Ratings downgrades for mortgage securities have pushed a clutch of such deals into default. Trustees have issued default notices for more than 14 collateralised debt obligation deals in recent weeks, representing securities with a face value of more than $10bn.

A default means the most senior investors in the CDO can liquidate the underlying assets to get their money back. Analysts say more deals are on the brink of default.

$10 billion is a pretty small amount by bond market standards, but the process of liquidating CDO assets is going to weaken prices even further in the mortgage securities market, and financial institutions will have to remark their positions in line with these new, lower values. And there is every reason to believe that CDO liquidations will accelerate.

Another problem that investors are discovering to their dismay is that CDOs have a tremendous amount of embedded leverage. That means, in lay terms, that comparatively small changes in the cash flows from their underlying assets have a large impact on their value. That is why, when the rating agencies re-rate the CDOs, the downgrades can be staggeringly large, not a mere one or two rating grades, but 11, 13, even an unheard of 18 grades.

And this casts the ratings into even further doubt. What does a triple A mean if, as one wag put it, you can go to lunch and due to a downgrade, you can come back and find that it is now junk? That simply doesn’t occur with other instruments in the absence of fraud. So the problem isn’t simply that the rating agencies might have come up with overly high ratings when the CDOs were issued because they had overly optimistic estimated for likely defaults. You have the further problem that any downgrade is likely to be dramatic. So even if you believed that your CDOs AAA was really an AAA, you’d still value it less than AAAs on other securities because the downgrade slope is so steep.

More than $350 billion of collateralized debt obligations comprising asset-backed securities may become “distressed” because of credit rating downgrades, Morgan Stanley said in a report today.

“The pace of ABS CDO downgrades will pick up significantly over the next few weeks,” wrote analysts led by Vishwanath Tirupattur in New York. “Given the degree of market dislocations and the potential size of the market, there is clearly an opportunity for attentive investors.”…

Bonds are considered distressed when investors demand yields at least 10 percentage points above similar-maturity Treasuries. Morgan Stanley said many of the CDOs of asset-backed securities sold in recent years are trading on an interest-only basis, signaling investors expect to receive little of their original principal back.

I for one would not try to catch that falling safe. While the higher-rated tranches of many CDOs almost certainly have some value, the problem is that these instruments were sold way beyond their natural market due to misplaced confidence in their ratings. Consider how small the market would be if the paper carried no rating.

Moreover, most fixed income investors are professional money managers subject to performance pressure. Even if one of them thought certain CDOs were cheap, he’d still hesitate to buy them out of concern that the prices would drop further before they rallied, and he’d show losses on those positions (and worse, have to explain to his boss and/or clients why he bought CDOs). Very few are going to step in until the market appears to be improving, and between now and then, we are likely to discover there is way too much CDO paper relative to who wants to own it now.

And let’s consider an ugly factoid. In its third quarter results, Merrill wrote down its CDO holdings by an estimated 30% or more. These were reported to be almost entirely AAA rated. This does not allow for either the further deterioration, nor the fact that downgrades are proceeding, which will impair value even more.

Take an estimated $3.0 trillion in CDO outstandings. Apply a mere 25% loss to them. That’s $750 billion, roughly four times greater than mainstream estimates of subprime losses.

Now admittedly there is subprime paper included in those CDOs, so there is some double counting, but the CDOs’ subprime holdings reportedly contain mainly the BBB/BBB- tranches, which is a portion of the value of the initial RMBS securitization.

Houston, we have a problem.

Update 11/13, 3:30 AM: Thanks to the Financial Times’ MergerMarket blog (hat tip Felix Salmon) we have some better data on CDO market prices, and how much Merrill wrote down various grades of CDOs:

However, AAA rated subprime CDOs currently trade from the high single digits on junior tranches to 60% of face on super senior tranches, according to a sellsider and a buysider…..

Merrill Lynch in the third quarter discounted its own super senior ABS CDO holdings by an average 19%, while mezzanine AAA notes were written down by 37%.

22 comments

Apples and oranges – it’s not the leverage that creates the losses – it’s the underlying assets. Leverage only channels underlying losses.

Sub-prime loans are an asset category. CDOs are effectively a liability category. You can’t compare the two in terms of loss expectation. The question is what underlying asset categories in addition to sub-prime loans (already scoped at the macro level) will end up causing losses via CDOs.

As to CDOs being a “liability category,” it isn’t clear what you mean by that. Investors carry them on their books as assets and have to write them down just like any other asset when their value falls. If Merrill Lynch has had written down its liabilities by $6.4 billion, as it did with its CDOs, it would have increased its profit.

CDOs are resecuritizations. They were purchased with the expectation of receiving interest and principal., just like any other fixed income investment. They were designed to take advantage of the fact that there is more demand for AAA paper than can be satisfied by companies that have an AAA bond rating (although ti turns out that too much of this substitute AAA paper was created).

If you are saying some subprime assets went into CDOs and there is double counting in the estimate, that’s a fair point, but the subrpime paper that went into CDOs was reportedly mainly BBB and BBB- tranches, which is a small portion of the total value of RMBS securitizations.

“Investors had carried CDOs on their books at more that they were probably worth, at first out of ignorance, … and later out of convenience…”

I’d go for old-fashioned greed being mentioned here as well. As you’ve written (sorry, don’t have the links), many CDOs were in the too-good-to-be-true category – less risk, higher yield. It should have been pretty obvious that this really wasn’t possible, and that they had to be worth less than face.

My point boils down to the potential for double counting of aggregate credit risk, which you mentioned. Conversely, it means identifying the underlying asset categories packaged within CDOs that would constitute aggregate credit risk in addition to the ‘primary’ asset categories such as sub-prime mortgages.

More abstractly, a derivative (e.g. CDO) of primary credit risk (e.g. mortgages) can’t really create more aggregate credit risk for the system than the original primary credit risk.

Pushing it further, CDO squared or cubed risk can’t really multiply the credit risk arising from the original underlying assets.

I suppose one counterargument to this might be that layers of leverage introduce additional systemic liquidation risk – and that might lead to lower marks – and greater write-offs, but it doesn’t change the true ultimate credit risk of the original asset categories (e.g. mortgages). If financial institutions are forced to mark rigorously to such market indices as the ABX, there may come a point where they over-mark around the point of a bottoming and reversal of that index. The result would be reversals of write-downs. The more liquidations that are forced, the greater the risk of that overshoot in marks, I think.

The ‘liability categorization’ was an awkward reference to the relative positions of intermediation in a CDO – if you look at the balance sheet of a CDO holding mortgages or securitized mortgages for example, the assets are the instruments that original the credit risk and the liabilities are the CDO capital structure.

1. A lot more paper went into CDOs than just subprime. The Venn diagrams of the two markets overlap, but they are largely additive. A lot of collaterlaized loan paper went into CDOs as well, as did the lower rated tranches of regular MBS, and I forgot to mention commercial real estate loans as well. I have seen greatly varying estimates of how much subprime went into CDOs, but my recollection (and it could be considerable off, reader input appreciated) is $400 billion. If the estimates of the size of the CDO market are accurate, it is 20% or less of the total. We’ve also seen estimates that 70% of CDOs have subprime exposure, but that’s a far cry from saying that 70% of CDO are composed entirely of subprime.

Another factoid from Bloomberg:

Buyout firms from Kohlberg Kravis Roberts & Co. to Blackstone Group LP have been among the biggest beneficiaries of CDOs. High-yield, or leveraged, loans financed 57 percent of the record $1.55 trillion of mergers and acquisitions last year, the most in seven years, according to S&P.

2. I tweaked the post a bit, and added that the total market estimates in many cases also include synthetic CDOs, which are CDOs made of credit default swaps on other CDOs. The assets in the initial CDOs have effectively had two CDOs made out of them (although the value of the synthetic CDO is presumably considerably lower than the total of the assets in the initial CDOs on which the CDS were written, but I have no idea how much smaller). However, the amount of synthetic CDOs sold in the first quarter of 2007 was reportedly over $100 billion. That alone is large when compared to the size of the subprime market, and those CDOs clearly are additive, not double counted.

Yves, these enormous numbers have less meaning than might be supposed. Let’s accept your estimate that there are $4T in wobbly CDOs and that something like 25% of the underlying mortgages are likely to fail to perform, i.e. $750B.

But why are those mortgages likely to fail? For the most part because the rates adjust. In other words, if the mortgage holder or the federal government or someone else eats the rate adjustment, the underlying mortgage becomes sound. And indeed, they may only have to eat it for a few years. Incomes rise over the time of a mortgage, in part due to inflation, in part due to demographics. In cases where there was misrepresentation by the seller’s agents, it would be entirely appropriate to have the feds step in.

Now, some–many– mortgages will and should fail. But to service all $750B of mortgages would cost on the order of $50B/year. And if we consider financing only the gap between the owner’s income and a fair mortgage rate, it’s far less.

If there is a financial collapse, it will not be because the problem is overwhelmingly large. It will be because the political system– and I include the petty, ugly jealousy directed against subprime borrowers in that– is morally too small.

Although there may be overlap in subprime and CDO, it seems that the term subprime often does not cover the magnitued of the toxic loan problem, as shown in the IMF ARM reset graph making the rounds. Alt-A ARMs and Option ARMs are also going to have big issues – a decent FICO score is not going to save most of those borowers.

The post above stressed that the CDOs contained other types of assets besides supbrme, in particular, the lower-rated tranches of RMBS, commercial real estate loans (and as Fitch has warned in several notes, commercial real estate showed the worryingly similar frothy practices as supbrime) and LBO loans (which some credit analysts say will be a new source of credit trouble if/when the economy goes into a recession).

To your comment which was effectively “the real estate defaults can’t trigger a problem of this magnitude” you are missing the other element of these structures: high embedded leverage.

Once these deals blow through their credit enhancement (and remember, they were done on very low subprime default assumptions, so we are already past that point in deals with subprime) small falls in the underlying payment stream produce much larger falls in the value of the CDO.

The quote submitted by Bob illustrates the point well. We are already way past a 2% fall in housing prices. The numbers I have seen are 8% and more is coming. And again as the post said, downgrade = loss.

The third factor is no one knows (or at least very few people) know what the stuff is worth. It reportedly takes a weekend by a knowledgeable analyst to value some of these deals. All a lot of buyers know is that this stuff isn’t what they thought it was, and they are unlikely to buy it even if it gets very cheap.

So beyond the decline in fundamental value we are going to see an even greater fall in market value due to a supply/demand imbalance. And a lot of parties, particularly investment banks and banks, have to mark their positions to market. These losses will be realized.

Previous news – but prices and ratings are a function of liquidation, or not:

TOKYO, Nov 9 (Reuters) – The trustee of a $1.5 billion collateralised debt obligation (CDO) managed by State Street Global Advisors has started selling assets, apparently starting a process of liquidation, Standard & Poor’s said late on Thursday…

S&P said it slashed its ratings on Carina CDO Ltd’s top tranche of securities by 11 notches to the junk level of BB from the top-notch triple-A after it received a notice on Nov. 1 saying that the controlling noteholders had told the trustee to liquidate. S&P also chopped its ratings on the subordinate levels of the CDO, with two falling to CCC- and eight to CC. The ratings were first assigned in November 2006…

Last month, S&P put 590 ratings on 176 CDOs — including those on Carina — on watch for a possible cut, affecting $20.6 billion in debt. The ratings cut on the Carina CDO is MORE SEVERE THAN WOULD BE JUSTIFIED BY THE DETERIORATION OF THE UNDERLYING ASSETS because a decision to liquidate would depress prices and affect all notes that were issued, S&P said. S&P said the ratings on the top two parts of the CDO would only be trimmed by one or two notches if the liquidation notice were withdrawn, but any selling will lead to material losses and market prices may not recover during the liquidation period. The liquidation notice follows an event of default notice on Oct. 22, which occurred after a collateral trigger in the structure was tripped. That notice led Moody’s Investors Service to slash its ratings on Carina on Oct. 30.

There are so many people commenting on CDOs at the moment that simply don’t understand them. The fact that most people are missing, which one of the more sensible comments already refered to, is the fact that CDOs only repackage already existing securities (or synthetic credit risk for synth. CDOs). In other words, the overall credit exposure, which a diversified investor base carries, remains the same, with or without CDOs, and therefore CDOs is merely a distribution model which parcels the risk (underlying assets) into a tranches that suit the risk appetite (or aversion) that investors have.

To assume, as you did in this post, that the total outstanding on CDOs (whatever the size may be), could suffer a 25% loss, is just ridiculous, considering that most of these assets are indeed very sound and performing. A 25% loss, whether realized or implied by mkt prices, means that 50% of the underlying credits would default (assuming a 50% average recovery value), compared to the current default rate of below 2%. It is clear, however, that the current mkt dislocation, driven mainly by a supply overhang, as too few people want to step in front of this train (yet), has driven prices significantly lower, but let’s try to keep our hair on.

Yes, but they also use the “credit enhancement” rackets to “promote”, for example, BBB and BBB- ABS toxic sludge to AAA ratings. So they end up with people who have no appetite for the risk they are taking. Or, maybe the high rating allows them to be used as collateral for other “investments”, increasing the leverage and therefore the damage done. Either way, the phoney rating is an economic distortion, if not outright fraud.

Finally, after seeing this crap at AAA, will anybody ever again trust S&P, Moody or Fitch? I sure won’t.

“Loss” means “reduction in market value.” Since most buyers were using now repudiated credit models for pricing, and there is no standard pricing model for this stuff, price is the eye of the beholders. And the beholders now realize they bought stuff that is too arcane for their taste.

You give the impression that these are simple mutual funds of heterogeneous assets, and completely ignore the role of having a significant portion of CDO assets be the weaker tranches of structured credits, which already have embedded leverage (their value will go to zero while their is still value in the senior tranches, that’s the whole point of the subordination) into another structured CDOs have high embedded leverage, yet you ignore this fundamental feature.

A example in the October Bank of England Stability Report work through how quickly BBB- tranches erode. An increase in the five year default rate from 25% (assumed in the deal’s design) to 35% reduced the value by 36%. If in addition to that, the loss upon foreclosure increased from 20% (assumed level) to 30%, the value of the BBB- tranche fell by 60%.

Even though CDOs do not consist primarily of subprime, the point of that illustration is that material deterioration below the deal’s assumed loss/default rates has a dramatic effect on the value of BBB and BBB- tranches.

Remember, Alt-As and option ARMs were also included in these deals. They are showing much higher default rates than anticipated too. And most important, the mortgage recovery rates these days are terrible. 70% used to be a good working assumption; I have read estimates of 50% and below. Mortgages were made with little to no equity and the fall in housing prices has been dramatic.

Moreover, it is certain that whether the monolines are downgraded or not, the market (CDS swap prices) says they are no longer AAA. So any CDOs that received credit enhancement via them will be worth considerably less. This is an effect independent of the value of the underlying assets.

And that doesn’t even get into the lack of demand issue. Even if this stuff on some theoretical basis is worth 85 cents on the dollar, if no one will pay more than 60 cents, the loss will be 40%.

Merrill marked down its AAA rated CDO portfolio by 30% or more. While most of the value of CDO paper is in the AAA tranches, a significant portion is not. That will be even more impaired. Tell me why readers should believe that Merrill’s CDO paper was vastly worse than other CDOs in the market. And if other investment banks mark down their “super senior” tranches that much or more, assuming they still even are rated AAA by year end.

These writedowns are very public and are an official statement of what their market value is deemed to be. It will most certainly affect how others holding CDOs will view and mark their positions.

Yves said, To your comment which was effectively “the real estate defaults can’t trigger a problem of this magnitude” you are missing the other element of these structures: high embedded leverage.

I assure you that I am not missing this, Yves. I am saying that the cost of preventing deleveraging is substantially less than the cost of allowing it. If, for the want of a nail the battle is lost, then the battle can be won for the price of a nail.

I also understand that there are other categories of loans bundled into CDOs. Without doing book length posts, it’s hard to deal with all the details, but the subprime issue is emblematic. Mortgages don’t get paid either because the borrower didn’t have the money to begin with (fraud) or because rates adjust up and the borrower’s income doesn’t or because something changes in the borrower’s life to make it impossible to pay (illness, unemployment, etc.)

The supply/demand imbalance due to difficulty of valuation that you describe is characteristic of panics from time immemorial. The federal government can step in, guarantee that the players get enough time to do the valuation, and the panic is over.

It probably won’t happen, because there is no leadership in Washington. But this disaster does not have to happen. ___________________H stated that “To assume, as you (Yves Smith] did in this post, that the total outstanding on CDOs (whatever the size may be), could suffer a 25% loss, is just ridiculous.”

Actually it’s not. It’s essentially identical with the assumption that 25% of recent mortgages default, which is more or less what the actual performance numbers are looking like. Yves is perfectly correct that if nothing is done, this will turn into a giant problem.

Thanks for your comment. I agree if there was some way to attenuate the deleveraging, it would be vastly better for all parties concerned. But there are a lot of losses out there that will eventually be recognized.

And then we have the prevailing belief in the “let the market clear” construct. For big but not overwhelming overvalued asset classes, that is probably the best, or more accurately, the less bad, solution (even though it damages innocents, the alternative, of shoring up the market, means the same perps will do it again on a bigger scale and create even more collateral damage down the road).

The powers that be like to hold up the Resolution Trust Corporation, which sold off the assets of brain dead S&Ls, as a great success, but they forget a few things. First, the S&Ls had failed. That’s why the government had to deal with the assets. Um, do we want financial institutions to fail here? No one would say that, but it is implicit in the model.

Second, the RTC was very controversial at the time, and its reputation has been burnished after the fact. It sold a lot of assets for much less than it could have gotten, partly due to inexperience (this was a vast new undertaking) and partly due to time pressure (Congress did not like the cash drain of funding RTC working capital).

Third, the recovery of the economy was due largely to Greenspan driving short-term rates very low. The steep yield curve that resulted was a massive subsidy to the banking system.

That’s a long-winded way of saying I agree with your general point, but even independent of the ideological obstacles, I don’t see a neat way of ameliorating the situation. And I haven’t seen any great or even good proposals either. The best ideas are on the regulatory reform front, but while desperately needed, that does not address the immediate crisis.

Excellent discussion regarding CDO’s. My biggest concern is the extent that nearly all asset classes are overvalued. I am no expert, but I do remember Long Term Capital Management nearly taking down the financial markets due to 4.6 billion in losses. Luckily the Fed stepped in and forced the bailout issue with all the major banks.

Now, it seems like the major banks themselves are writing off huge sums of money which as reported currently amounts to at least 45 billion dollars. I have a few questions if anyone knows:

Which were the largest write offs in history in terms of overall economic impact?

How do they compare to the $45 billion in write offs the banks have already acknowledged the past few weeks?

Well, if by “trust” means consider their analysis as one factor in making an investment, I should hope so. On the other hand, any one who depends exclusively on their ratings should have their minds examined; and laws that are based on their ratings should be changed.

And of course I have no sympathy for investors who knew they were getting a deal that was too-good-to-be-true (AAA rating with a yield much higher than Treasuries) and are now blaming the ratings agencies for their own greed.

Yves, I think that the S&L comparison is an excellent one. The very wealthy and connected did wonderfully in buying assets for far below market. “Letting the market clear” is a euphemism for “letting the fattest hogs feed alone at the trough.”

I also agree that the people who participated in fraud need to suffer some pain. I think that a fair conclusion can be accomplished by:1. Criminally prosecuting the worst cases 2. Providing aid only for owner-occupied primary residences3. Limiting aid to no more than the amount of mortgage resets4. Conditioning debt relief on borrower and issuer sharing any pain5. Unbundling CDOs into individual mortgages to restore transparency

I think that an annual expenditure of about fifty billion for five years, delivered as a mortgage guarantee, would serve. That will work its way through the system to reduce the deleveraging.

Any good solution must leave everyone unhappy… but, except for the outright crooks, solvent.